Sunday, June 03, 2007

Barnyard Forecast -- Stocks Going Higher

The Donaldson Capital Management Barnyard Forecast is our subjective model for the prospects of the stock market over the next 12 months. We like to roll it out when the times or the markets are confusing. The Forecast is a simple check list of the levels and trends of the major economic data and their historical relationships to stocks. The Forecast's name is taken from the acronym of its components: Economy, Inflation, Earnings, Interest Rates. Each component is rated as follows: positive for stocks --2 points, neutral for stocks -- one point, or negative for stocks-- 0 points.

Economy: The optimum rate of real economic growth is near 3%. The Forecast is positive when economic growth is below 3% and negative when its above 3%. At first that may seem counter intuitive, but the idea is to capture the projected actions of the Federal Reserve in the coming year. If the economy is growing slowly, the Fed can be expected to cut rates; if the economy is steaming, the Fed will likely raise rates. The most recent GDP data was this week's .6% reading for the first quarter. That is well under 3% and, thus, is positive for stocks, 2 points.

Inflation: This is the most worrisome indicator currently. The important threshold for the Core Consumer Price Index (Core CPI) inflation is 2%. The core CPI has been consistently above that level for nearly two years and has caused many analysts to be skeptical about rate cuts anytime soon. The reading for the 12 months ending April was 2%. Under the circumstances, that is a negative reading. 0 points.

Earnings: Corporate earnings have been nothing short of sensational over the last three years. Most analysts were predicting that first quarter earnings would fall below 10% on a year over year basis for the fist time since 2002. The final numbers are not in yet, but it appears first quarter earnings for the S&P 500 may have edged over that level. In any case, earnings have continued stronger longer than almost anyone would have guessed. The most important threshold for earnings is 7% annual growth, which is the long -run average. We expect 2007 earnings growth will stay comfortably above that level. Earnings are positive for stocks. 2 points.

Interest Rates: Long-term interest rates have been creeping higher over the last few months. Bond investors appear to be worried that the slowing economy will prompt the Fed to cut rates before inflation is completely subdued. Having said this, 30 year Treasury yields are about where they were a year ago. That is a neutral reading. One point.

The Barnyard Forecast totals 5 points. That is a modestly bullish reading for stocks in the coming year.

With stocks having had a strong run over the past 4 months, the media is full of prognosticators who are turning bearish. As seen below from the website , currently nearly 47% of stock market commentators included in their survey are bearish, with only 25% bullish. We have never seen a market turn decisively lower in the face of such negative sentiment. Stocks almost always turn lower when everyone is bullish. Just the opposite is true today and, thus, at the very least we should have another surge higher to force all the naysayers to capitulate and come off the sidelines.

This might sound like simplistic thinking, but over the years, we have found that markets that are littered with doubt and worry tend to be more profitable than those when the sentiment is overwhelmingly bullish.

Our Dividend Valuation Models say the market is still cheap. Our Barnyard Forecast says that economic forces favor a rising stock market. Lots of traders are bearish. It hasn't been this good in a long time.